What Difference Does a Percent or Two Make
What Difference Does a Percent or Two Make
It’s probably fair to say that most people don’t spend a lot of time thinking about the difference a percent or two in return makes in their financial plan. After all, the difference between earning 4% and 6% on a $100,000 investment is only a couple thousand dollars in a year. Not exactly life changing, right? But what if we are talking about a $500,000 investment? Or a $1,000,000 investment? Or a $5,000,000 investment? What if we are talking about ten years or twenty years or thirty years? Just a couple percent can have a huge financial impact when compounded over several years and the investment amount grows larger.
Let’s assume a 30 year old begins saving $300 per month towards retirement. When this person reaches age 65, they would have amassed the following wealth:
- At 6% rate of return = $427,413 (before tax).
- At 8% rate of return = $688,165 (before tax).
The difference of 2% per year is a staggering $260,752!
Just for fun let’s assume that the same individual, now age 65, changes the objective from building assets to income replacement and begins taking $2,867 per month in systematic distributions (5% distribution from $688,165) from the portfolio and does so until age 90. The total distributions over the 25 year period would be $860,100 ($2,867/mo. x 25 years) and the ending values would be:
- At 4% rate of return = $393,509
- At 6% rate of return = $1,085,822
The difference of 2% per year on the ending value is $692,313.
Now that we can all agree that just a couple percent per year can make a lifestyle altering difference over time, let’s address the main factors involved in attempting to achieve a better return. According to Dalbar’s 2015 QAIB report, the average investor underperformed the S&P 500 stock index by an average of 4.66% per year over the past 20 years.1 The major contributing factors to the underperformance include investor behavior and lack of diversification.
1. Investor Behavior
a. Market timing- Buying and selling based on perception of future price movements.
b. Media Response- A tendency to react to media reports or current headlines.
c. Loss Aversion- A tendency to strongly prefer avoiding losses to acquiring gains.
d. Volatility Response- A tendency to react negatively to volatility.
e. Paralysis by Analysis- Seeking too much information from too many resources can lead to indecision.
f. Unrealistic Expectations- A desire for a premium rate of return while attempting to avoid volatility.
2. Lack of Diversification
a. Unsystematic Risk- An under diversified portfolio will be subject to additional risk due to the inherent risk with individual securities.
b. Company Bias- A tendency to overweight in a certain stock due to personal ties, family connections or loyalty.
c. Geographic Bias- A tendency to overweight or underweight the positions in a stock portfolio based on geographic location.
d. Stock Picking- An attempt to outperform a market index through individual selection.
e. Risk Persuasion- The belief that there is an infinite relationship between risk and return.
The primary benefits of working with a professional advisory team is that they help clients avoid the investor behavior traps that can be very costly over time as well as provide guidance in building a broadly diversified and appropriately allocated investment portfolio.
- Rick O’Dell
